Big tax gap between individuals and corporations invites abuse

It was a hot and sunny Tuesday in Ottawa, with the mercury touching nearly 30 degrees.

Chances are few Canadians were reading details of a plan unveiled that day by federal Finance Minister Bill Morneau to clamp down on Canadians using private companies to lower their tax bill.

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But in the weeks since, the furor over Mr. Morneau's plan has grown loud, and increasingly testy. The Liberal government is facing a mounting backlash from doctors, dentists, farmers, shop owners and lawyers, who accuse the government of punishing hard-working entrepreneurs.

Mr. Morneau insists it's about tax fairness and levelling the playing field between a relatively few wealthy taxpayers who are exploiting tax rules, and the rest of us – the silent 99 per cent.

The targeted tax schemes – and Mr. Morneau's planned fixes – are complex, providing glimpses into an arcane world known only to accountants and their clients. The changes, slated to take effect in January, would address a clutch of tax strategies available exclusively to corporations, including the practice of "sprinkling," or distributing business income with family members in lower tax brackets. The legislation would also restrict the ability of business owners to convert income into capital gains, which are taxed at a lower rate.

There is a much simpler way to look at this debate.

This is a problem entirely of governments' own making. Recent tax changes by both this government, the previous Conservative government and various provinces have opened up a yawning gap between the top tax rates on individuals and corporations, especially small ones.

This has created powerful incentive for individuals, such as professionals, to turn themselves into companies. It's all legal, and accountants have been more than happy to help.

Top income earners now face a top marginal tax rate of more than 50 per cent in seven out of 10 provinces, including every one east of Saskatchewan.

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Meanwhile, the combined federal and provincial tax rates for small businesses, once in the high 20-per-cent range, have been cut nearly in half to less than 15 per cent over the past decade. Canada's rate is now the lowest among Group of Seven countries.

There are, of course, good reasons to incorporate, besides tax savings. They can offer protection from creditors and free up more profits to reinvest in the business.

But lower corporate rates are a powerful motivator. The number of private corporations swelled to 1.8 million in 2014 from 1.2 million in 2000.

Many of these newly incorporated businesses are doctors. Ontario started allowing doctors to incorporate in 2000 – a concession the province made after balking at doctors' fee demands. Nearly 70 per cent of Ontario's roughly 30,000 practising doctors are now incorporated, mainly for tax reasons.

The key here is that governments created the conditions that caused hundreds of thousands of Canadians to incorporate. In some cases, they even condoned and encouraged the shift.

And once granted, it's very hard to take away peoples' entitlements. Many business owners see these tax advantages as a way to fund their retirement, pay for childrens' education or reward spouses who have supported their careers.

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But Ottawa is right that its intent was never to let hundreds of thousands of Canadians use income "sprinkling" to accomplish those goals.

There are other ways for government to address tax unfairness. For starters, it could get rid of the preferential tax rate for small businesses, or deny its use by professionals and other business owners who don't have employees.

After all, there is scant evidence that the lower small-business rate is a successful tool to get companies to do good things, such as growing larger, hiring more workers and developing new products.

The government could also narrow the gap between the tax rates on income, and the much lower rates on capital gains. In the runup to this year's federal budget there was rampant speculation that Mr. Morneau would raise taxes on profits from stocks, real estate and other investments by raising the percentage of capital gains subject to tax. The move would have raised billions in additional revenue, largely from wealthier Canadians.

Mr. Morneau has explicitly taken that off the table.

This all leaves the impression that the Liberal government is itching for a fight over income inequality – with the 1 per cent, and with the Conservatives.

The Liberals may be less concerned about tax fairness than creating a wedge issue to take into the next election.

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